On using the SDR in private financial transactions
Pierre van den Boogaerde
The special drawing right was introduced in 1970 by the International Monetary Fund as an international reserve asset to be allocated to its members as a supplement to existing reserves. It has become the unit of account for all the transactions and operations of the Fund. Originally, its value was tied to gold. However, with the advent of floating exchange rates and the decision to allow the price of gold to be set by the market, the value of the SDR has been determined by a basket of currencies since July 1, 1974. The original basket consisted of the 16 leading currencies in international trade and payments. In part because the large number of currencies in the basket was perceived as a serious handicap for the wider use of the SDR outside the Fund, the Fund decided, from January 1, 1981, to reduce the number of currencies in the basket to the five most important currencies in world trade and international finance. Currently, the SDR is defined as the sum of 0.54 U.S. dollars, 0.46 deutsche mark, 0.74 French francs, 0.071 pounds sterling, and 34 yen.
The SDR is now extensively used as a medium of exchange and settlement between the Fund and its members and in addition may be held and used by 14 official institutions, the so-called prescribed holders. About 15 countries have pegged their currencies to the SDR, and about the same number of international or regional organizations use the SDR as a unit of account. A number of international conventions also use the SDR to express monetary magnitudes, notably liability limits in the international transport of goods and services.
As a private asset
Parallel to the development of the Fund’s, or “official,” SDR, international organizations, borrowers, and investors looking for a hedge against the current combination of considerable volatility and uncertainty in interest rates and exchange rate developments have started to use the same unit of account, creating the “commercial” or “private” SDR. The value of private SDRs is determined on the basis of the same basket of currencies as the official one, but private SDRs are subject to the conventions of the market place and are not constrained by the rules governing the uses of official SDRs. The simplification of the official SDR basket in 1981 made it more attractive to international financial markets, and it is now used to denominate a wide range of private financial instruments and obligations, such as commercial bank current accounts and deposits, syndicated loans, fixed and floating rate certificates of deposit, floating rate notes, and Eurobonds.
In fully arbitraged foreign exchange and capital markets, the ex ante total return (interest income plus currency appreciation or depreciation) expected from investments in otherwise comparable instruments is equal for all currencies—aside from legal constraints, convenience, or political risk. If expectations were always realized, any one such investment would do as well as any other, and there would be no benefit in using a basket. In reality, however—and this is even more true since the system of floating exchange rates became generalized—divergent and frequently revised expectations of inflation rates and real factors lead to sudden and often unpredictable movements in exchange and money markets, resulting in large discrepancies in ex post returns. A large and sophisticated organization may be able to monitor these fluctuations and to hedge by constructing a tailor-made basket of currencies. For the smaller or more conservative organization, it is often cheaper (and more practical) to use the standardized SDR to diversify the risk of being exposed to unavoidable and unexpected returns. When the SDR is used as the uniform denominator of international transactions, day-by-day monitoring of the currency composition of contracts and exposures is avoided and frequent currency conversions are reduced, resulting in economies of scale and reductions in transaction costs.
Both components of total returns—exchange rate changes and interest income—are more stable for the SDR than for individual currencies. The exchange rate is more stable since changes in the exchange value of the currencies in the basket are generally completely or partially offset by smaller or opposite changes in the values of other currencies in the basket. Thus, the SDR’s variability in terms of a particular currency will be less than the weighted average variability of its five individual components in terms of the same currency. (See Chart 1, which uses the U.S. dollar as the unit of account and shows the evolution of exchange rates over 1977–82 in order to encompass periods of both weakness and strength of the U.S. dollar.) By the same token, the interest income on the SDR represents a blending of interest returns. But because interest rates in different countries respond to common factors affecting the absolute level of yields in addition to movements in relative rates, they tend to move in the same direction, so the interest income on the SDR tends to be relatively similar to that on other currencies.
Chart 1SDR and component currencies: foreign exchange rate indices (monthly, 1977–82)
Source: IMF data.
Note: The calculations underlying the chart assume that the SDR basket existed in its 1981 form from January 1977 onward.
A recent study by the author, which assumed that the SDR basket had existed in its present form from January 1977, reviewed the relative attractiveness of SDR-denominated investments in terms both of its total returns, defined as interest income plus any net gain or loss on exchange rate changes, and its risks over 1977–82. It concluded that the variability of the total return on the SDR was generally lower than that of the returns on each of its component currencies, whichever currency was used as a unit of account. (Relative variability was captured by comparing standard deviations.) The only exception was the close relationship between the deutsche mark and the French franc because both currencies participated in the European Monetary System. Moreover, the SDR had an above average total return during the period, regardless of which currency is used as a unit of account (see Chart 2). There are good reasons to believe that the results of the study are not influenced by the period chosen.
Chart 2Risk return relationship, 1977–82
Source: IMF data.
Unfamiliarity brings costs
The intrinsic stability of the SDR, together with the fact that it provides a multicurrency diversification covering the three most important currency zones (the United States, Europe, and Asia) in the form of a single instrument, should have made the SDR attractive to a wide array of international market operators. But the use of the SDR in private markets has developed rather slowly. After the Fund reduced the size of the SDR basket in 1981, there was a burst of activity in private SDR instruments, but it was not prolonged and not widespread enough to create a self-sustained vibrant market. There appear to be five main reasons for this failure.
The first is the lack of familiarity with the SDR, partly due to investors’ natural aversion for complexity and novelty. Organizations involved in international transactions are used to coping with particular national currencies and have gained an intuitive knowledge of their value. Even those organizations that have looked into the SDR and perceived its natural risk-reduction benefit have not started to use it, in part because of the extra cost involved in introducing a supplementary, and for that matter, infant currency. Extra cost is entailed by its rather narrow spot and forward foreign exchange market, by its difficult transfer, and by the specific contract clauses it needs to accommodate the possibility that, at a certain point, the value of one of the constituent currencies cannot be determined or that the composition of the SDR could be changed.
The cost of its narrow exchange market is more apparent than real. Although no genuine two-way interbank foreign exchange market in SDRs has developed yet because of the low volume of transactions, a sizable number of banks quote both spot and forward exchange rates for the SDR because the number of currencies in the SDR basket is limited and the currencies are widely tradable. Similarly, the costs incurred by the need for specific clauses in contracts denominated in SDRs are less of a constraint on transactions than they were, as experience has accumulated with handling them.
But the difficulty of settling direct payments in private SDRs is very acute. At present, no international clearing arrangements for SDRs exist, so transactions have to be made in another currency or in the five constituent currencies of the unit. Private banks offering SDR-denominated current accounts to their customers usually maintain accounts with each other in order to make interbank transfers possible. But all payments are on a gross bilateral basis and the number of participant banks is limited. The formal establishment of a clearing mechanism would enable the settlement of net balances and thereby greatly enhance the attractiveness of the use of the SDR.
It is relevant that the European Currency Unit, created by the EMS to serve as its unit of account when it came into being in 1979, and consisting of the currencies of European Community countries (with the exception of Greece), used to be as unknown and complex as the SDR. (For a discussion of the EMS, see Horst Ungerer, “Main developments in the European Monetary System,” Finance & Development, June 1983.) Nonetheless, use of the ECU has grown much more rapidly than that of the SDR. A clearing system for the ECU is about to be formalized, and it is often treated as a currency in its own right. Its success is partly due to the fact that all of its component currencies are in a homogeneous trading area, but is principally the result of official support given by EC institutions, which triggered demand for it by the private market.
Another important reason for the neglect of the private SDR may be that the weights recently attributed to its constituent currencies did not reduce exchange rate risk sufficiently for certain, mainly European, organizations. The SDR does not offer a great deal of diversification for nondollar-based investors; it only includes five currencies, and the U.S. dollar, whose total return is relatively volatile in terms of these, is heavily weighted in the basket. (The weight of the U.S. dollar in the SDR in the last seven years fluctuated between a low of 42 percent in 1979–80 and a high of over 50 percent in 1983.) This raises the question of whether the preponderance of the U.S. dollar in the SDR basket might not have been excessive. One study of 1977–82 demonstrated that if a nondollar resident were not exposed to the U.S. dollar at all, the use of the SDR for an investment or as a unit of account would not have been the optimal solution over the period. The use of a basket with a much lower U.S. dollar content would have greatly increased the correlation between the returns on the nondollar resident’s native currency and the returns on that basket, thereby more effectively diversifying his total risk. Thus, a more appropriately tailored basket would have been more effective because it would have coincided more closely with the needs and exposure of the nondollar resident.
While there is some merit in the argument that the weight of the U.S. dollar has been excessive from the point of view of many nondollar-based organizations, two conditions nevertheless favor the present composition of the SDR basket. First, the important weight of the dollar may, of course, be temporary. The U.S. dollar experienced an unprecedented appreciation from 1981 to 1983, which could be reversed in the coming years, thereby automatically reducing its value share in the SDR basket. Second, given the preponderant role of the U.S. dollar in international trade and international financial markets, most public and private international organizations—even in Europe—are either U.S. dollar-based or have a large U.S. dollar exposure, which is precisely why the U.S. dollar was given such a large weight in the first place. Consequently, the SDR remains attractive as a “world hedge,” though, admittedly, it may be too global a hedge for organizations that are only exposed to a number of regional currencies. This latter phenomenon partly explains the recent success of the ECU in European financial markets. The strength of the U.S. dollar may have been a third reason for the lack of interest in the SDR, because it reduced incentives to find an alternative.
Because the private SDR market is small, it is vulnerable to retrenchment by large participants. Moreover, although the official SDR was gradually given financial characteristics similar to those of other major reserve assets, the Fund did not actively contribute to the establishment of a private market for SDR-denominated instruments. It has already been mentioned that the initial use of the ECU in private markets was officially orchestrated; the European Communities as a whole, the European Investment Bank, and EURATOM have all launched bond issues in ECUs and been active depositors in ECUs. The EIB has, in addition, extended part of its loans in ECUs and made it a precondition for obtaining these loans that the amount be deposited in ECU accounts. The EC Commission initiated the establishment of a banking group to study the possibility of a clearing institution in ECUs. Similar promotion has been completely lacking for the SDR.
The private SDR could be revived if international market operators anticipate that the considerable volatility and uncertainty in interest and exchange rate developments of recent years are likely to continue and should be hedged. Both the Fund and its member central banks could play an important role in making an adult of the infant currency and broadening familiarity of the private sector with the SDR, which would automatically increase its use.
Specifically, the Fund could promote the SDR by being fully committed to support the private use of SDRs, by augmenting its resources through borrowing SDRs from the private market (a principle on which there is not as yet full consensus), by encouraging more member countries that peg their currencies to do so to the SDR, and by creating or encouraging the creation of a settlement system for international payments in SDRs. It could, for instance, issue debt certificates denominated in SDRs in the private market, which would improve the ability of banks to match SDR liabilities against true SDR assets, rather than covering their exchange exposure with a currency cocktail. If these certificates carried the requirement that they be purchased with private SDRs, and if the Fund paid interest on them by transferring some of its holdings of private SDRs, the development of SDR payment arrangements would be stimulated. Moreover, liquid assets of the Fund’s Administered Accounts could be made the object of SDR deposits with various private institutions rather than being deposited solely with the BIS, thereby bolstering the interbank activity in SDRs.
The central banks could contribute to wider private SDR use by using their SDRs for frequent transactions—including intergovernmental settlements—rather than holding them, as they generally do, as a sterile reserve currency, except when SDRs are used for transactions and operations with the Fund; by having some of their foreign borrowing denominated in SDRs; by encouraging the use of the SDR for governmental investments contracted abroad and paid for in foreign units; and by widening the sales of governmental securities to include instruments denominated in SDRs.
These measures could increase the use of the SDR. If more countries pegged their national currency to the SDR, an extra foreign exchange risk would be introduced with the reception or payment of national currencies. This would increase the demand for payments in SDRs. More frequent bond issues and syndicated loans denominated in private SDRs would result in an active secondary market. Private organizations would gradually be attracted first to invest in SDRs and subsequently to issue debt denominated in that currency.
The private banking system would quickly adapt itself to the increased demand for SDRs by enlarging the number of financial instruments denominated in SDRs, by increasing their usage, and by reviving the interbank market in SDRs. This could snowball as more organizations start to use the SDR in place of national currencies for international transactions; invoicing in SDRs in international markets would then become the norm rather than the exception.
While such a large-scale voluntary use of the SDR as a unit of account is still unrealistic, both the intrinsic stability of the SDR and the possibility that volatile exchange and interest rates will prevail for the foreseeable future might entice a number of international market operators to use the SDR as a unit of account in the near future.